OM SAI RAM

COMPILED CA Vikas gOWDA

BY: E-Mail: cavikasgowda.edu@gmail.com
 Cs-executive
module 2
• Paper 8: financial &
Strategic management

Financial management Index

(Part A- 60marks)
Chapter
Name of the Chapter Page No.
No.
Nature, Significance & Scope of Financial
1) 1 to 3
Management
2) Time Value of Money & Capital Budgeting 4 to 9
3) Capital Structure & Leverage Analysis 10 to 14
4) Sources of Long-term Finance & Cost of Capital 15 to 17
5) Project Finance -
6) Dividend Policy 18 to 20
7) Working Capital Management 21 to 26
8) Security Analysis 27 to 31
9) Portfolio Management 32 to 37

Its Revision time

 Financial Management Revision Notes
CHAPTER-1

NATURE, SIGNIFICANCE AND SCOPE OF FINANCIAL MANAGEMENT

Finance Finance function is the procurement of funds and their effective utilization in business
concerns. It may also be defined as an art or a science of managing money.
Business Business finance is that business activity which concerns with the acquisition and
finance conversion of capital funds in meeting financial needs and overall objectives of a
business enterprise.
Financial Financial Management deals with procurement of funds and their effective utilizations
management in the business and concerned with investment, financing and dividend decisions in
relation to objectives of the company.
Raising of funds should involve minimum cost and to bring maximum returns.
Types of
Financial Financial
Decisions Decisions

Investment Financing Dividend

Decision Decision Decision

Working
Capital Cost of Capital
Capital
Budgeting Capital Structure
Management

Financial Management is concerned with all three investment, financing and dividend
decisions in relation to objectives of the company.
Investment decision ordinarily means profitable utilization of funds. Investment
decisions are concerned with the question whether adding to capital assets today will
increase the net worth of the firm.
Financial decision making is concerned with the question as to how funds requirements
should be met keeping in view their cost, and how far the financing policy influences
cost of capital.
Dividend decision helps the financial manager in deciding whether the firm should
distribute all profits or retain them or distribute a portion and retain the balance.
Management needs to ensure that enough funding is available at the right time to meet
the needs of the business.
Value of firm- A finance manager cannot avoid the risk altogether nor he takes a decision by
risk and return considering the return aspect only. Usually, as the return from an investment increases,
the risk associated with it also increases. Therefore, a finance manager is often required
to trade-off between the risk and return to maximise the market value of the firm.
A particular combination of risk and return where both are optimized may be known as
Risk-return trade off and at this level of risk-return, the market price of the shares will
be maximised.

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Liquidity Liquidity is defined as ability of the business to meet its short- term obligations. It shows
the quickness with which a business/company can convert its assets into cash to pay
what it owes in the near future.
Liquidity is assessed through the use of ratio analysis.
Current Ratio Current Assets
Current Liabilities
Ideal ratio is 2:1.
Quick Ratio Quick Assets
Current Liabilities

Cash Ratio Cash & Bank balances + Marketable Securities

Current Liabilities
Working Current Assets - Current Liabilities
Capital Ratio

Profitability Profitability as a decision criterion is another important tool in financial management for
taking decisions from different angles after evaluating the performance of the company
in different spheres.
Profitability Ratios based on sales:
Gross Profit Ratio Gross Profit
X 100
Sales
Net Profit Ratio Net Profit
X 100
Sales
Operating Profit Operating Profit
Ratio X 100
Sales

Profitability Ratios related to overall return on

Assets/Investments:
Return on Return/Profit/Earnings
Investment(ROI) X 100
Investment
Return on Net Profit after taxes
Assets(ROA) X 100
Average total assets
Return on Capital EBIT
Employed(ROCE)- X 100
Capital Employed
Pre-tax
Return on Capital EBIT(1-t)
Employed(ROCE)- X 100
Capital Employed
Post-tax
Return on N.P after taxes - Pref. Dividend
Equity(ROE) X 100
Net Worth/ESH Fund
There is an inverse relationship between liquidity and profitability. While the immediate
survival of a business depends on its liquidity, its long term survival and growth depend
on profitability.
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Costing and risk:
Financial risk The use of borrowed funds or fixed cost funds in the capital structure is financial risk or
financial gearing/leverage.
Business/ Business risk is associated with the chance of loss due to variability of return, created by
Operating risk the enterprise and as such it is known as operating risk.
Operating risk is concerned with EBIT whereas financial risk is concerned with EAIT.
Purchasing Purchasing power risk affects all investors. The risk is associated with changes in the
power risk price level on account of inflation. Under inflationary conditions, the purchasing power
of money decreases over time, and the investor is faced with the possibility of loss on
account of investments made to the extent of inflation.
Interest rate risk Interest rate risk is concerned with holders of the bonds due to changes in interest rates.
If interest rate falls, the price of the bonds will rise and vice versa.
Social and Social and regulatory risks arise due to harsh regulatory measures like licensing,
regulatory risks nationalisation, price controls limiting profits, etc.
Objectives of a
firm Profit maximization Shareholder Wealth maximization
Profit maximisation causes the efficient Shareholder wealth maximization means
allocation of resources under the maximizing the net present value of a
competitive market condition and profit course of action to shareholders.
is considered as the most appropriate NPV = Present value of benefit - Present
measure of a firm‟s performance. value of costs
Profit maximisation is basically a single- Shareholder wealth maximisation is a
period or, at the most, a short-term goal. long-term goal and shareholders are
interested in future as well as present
profits.
Profit maximisation is the narrow Wealth maximisation is comprehensive
objective objective
Wealth maximisation objective is therefore, superior to the profit maximisation concept.

Economic Economic value added (EVA) is the after tax cash flow generated by a business minus
Value-Added the cost of the capital it has deployed to generate that cash flow. Representing real profit
(EVA) versus paper profit, EVA underlines shareholder value.
EVA = (Operating Profit) – (A Capital Charge)
EVA = NOPAT – (Weighted average Cost of Capital x Capital Employed)
Market Value Market Value Added concept shows the management the increase or decrease in the
Added value of capital.
Market Value Added = Market Value of Capital – Book Value of Capital
Financial Generally the affairs of a firm should be managed in such a way that the total risk –
Distress and business as well as financial borne by equity holders is minimised and is manageable
Insolvency otherwise, the firm would obviously face distress.
Firm may have to sell its assets to discharge its obligations to outsiders at prices below
their economic values i.e. resort to distress sale. So when the sale proceeds is inadequate
to meet outside liabilities, the firm is said to become bankrupt or (after due processes of
law are gone through) insolvent.

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CHAPTER-2

TIME VALUE OF MONEY & CAPITAL BUDGETING

TIME VALUE OF MONEY:

One of the most fundamental concept in finance is that money has a “time value.” That is to say that
money in hand today is worth more than money that is expected to be received in the future.

Some standard calculations based on the time value of money are as follows:
Present Value Present value refers to the current worth of a future sum of money or stream of cash flows
given a specified rate of return.
PV = Future Cash Flow/ (1+r)t
We can rewrite the above equation as under:
Present value = Future value x Present value factor
PV = Fn x PVFn,i
Higher the discount rate, the lower the present value of the future cash flows.
Future Value of Future value of a lump sum refers to the value after a certain period of time at the given rate
a lump sum of interest.
FVt = CF x (1+r)t OR FV = PV x (1+r)t

Note: Present value will always be less than future value.

And Present value factor will always be in decimal i.e less than 1.
Future Value of An annuity is a stream of equal regular periodic payment made or received for a specified
an Annuity period of time.
FVAn = R x (FVIFAi,n)
Present Value of Sometimes instead of a single cash flow the cash flows of the same amount is received for a
an Annuity number of years.
PVAn = R x (PVIFAi,n)
Note: Under annuity concept, the annual cash flows i.e R should be equal.
Perpetuity Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date
and continue indefinitely or perpetually.
Calculation of Multi Period Perpetuity:
PVA = R / i
Calculation of Growing Perpetuity:
A stream of cash flows that grows at a constant rate forever is known as growing perpetuity.
PVA = R / i – g

Sinking fund It is the fund which is created for a specified purpose to be fulfilled at future date, by way of
sequence of periodic payments over a time period at a specified interest rate.
Size of the sinking fund deposit is computed by using the formula i.e.
FVA= R x [FVIFA(i,n)]
Note: R = Equal annual cash flows
Net Present NPV = P.V of Cash Inflows - P.V of Cash Outflows
Value (OR)
NPV = P.V of future Cash flows - Initial Cash Outflow

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CAPITAL BUDGETING:

Capital Budgeting is the process of determining which capital expenditure project should be accepted
amongst various projects and given an allocation of funds from the firm.

Allocation of capital resources function involves organisation‟s decision to invest its resources in long-
term assets like land, building facilities, equipment, vehicles, etc.

Kinds of Capital Budgeting Decisions:

Business firms are confronted with three types of capital budgeting decisions which are -
a) Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the
proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment
proposals which yield a rate of return greater than cost of capital are accepted and the others are
rejected. Under this criterion, all the independent prospects are accepted.
b) Mutually exclusive decisions: It includes all those projects which compete with each other in a
way that acceptance of one precludes the acceptance of other or others.
c) Capital rationing decisions: Capital rationing refers to the situations where the firms have more
acceptable investments requiring greater amount of finance than is available with the firm. It is
concerned with the selection of a group of investment out of many investment proposals ranked in
the descending order of the rate of return.

CAPITAL BUDGETING TECHNIQUES

Traditional or Non- discounted cash flow techniques:

These techniques do not discount the cash flows to find out their present worth.
Payback Period This technique estimates the time required by the project to recover the firm‟s initial
Method outlay, through cash inflow.
Initial Investment
Payback Period =
Annual cash inflows

Where the cash inflows are not uniform, cumulative cash inflows will be calculated
and by interpolation exact payback period can be calculated.
Decision Rule:
Accept the project if the payback period computed is less than the maximum set by
the management.
In case of multiple projects, the project with shorter payback period will be selected.
Average Rate of Average Profits
Return (ARR) or ARR =
Initial Investment
Accounting Rate of
Return Method Decision Rule:
Accept the proposal if ARR > Minimum rate of return (cut off rate) and
Reject the project if ARR < Minimum rate of return (cut off rate).
In case of multiple projects, the project yielding a higher rate of return will be
preferred.

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Modern or Discounted cash flow techniques:
Under this method, the cash flow discounted at the projects discount rate to the present time, is a present value.
Net Present Value NPV = P.V of Cash Inflows - P.V of Cash Outflows
Method (NPV) (OR)
NPV = P.V of future Cash flows - Initial Cash Outflow
Modified NPV Under this modified approach, terminal value of cash inflows is calculated using
reinvestment rate.
Thereafter, MNPV is determined with present value of such terminal value of the
cash inflows and present value of the cash outflows using cost of capital (k) as the
discounting factor.
Terminal Value = CF (1+r)n-t
MNPV = {TV ÷ (1+K)n} - Initial Investment
Internal Rate of The internal rate of return refers to the rate at which P.V of cash inflows and P.V of
Return (IRR) cash outflows are equal.
In other words, it is the rate at which NPV of the investment is zero.
Step 1: Calculate PVAF using the following formula-
Initial Investment
PVAF =
Average cash inflows
Step 2: Find out in present value annuity table, for given period at what percentage
value is nearest to our calculated PVAF. Such percentage will be the approximate
IRR.
Modified IRR Step 1: PVC = Present Value of the cash outflows or Initial investment
Step 2: Terminal Value (TV) = ∑ CF (1+r)n-t
Step 3: PVC = TV / (1+MIRR)n
Modified NPV or Modified IRR may be used to resolve the conflict in ranking of
the alternative projects under NPV and IRR methods.
Profitability Index P.V of Future cash flows
(PI) Method Profitability Index =
Initial Investment
Decision Rule:

Proposal Net Present Value Internal rate of return (r) Profitable Index(PI)
Accept Positive >k >1
Indifferent Zero =k =1
Reject Negative <k <1
In case of more than one project/ proposals, the project with higher NPV/IRR/PI will be selected.

In case of mutually exclusive projects, financial appraisal using NPV & IRR methods may provide conflicting
results. The reasons for such conflicts may be attributed to-
i. Difference in timing / pattern of cash inflows of the alternative proposals (Time Disparity),
ii. Difference in the amount of investment (Size Disparity) and
iii. Difference in the life of the alternative proposals (Life Disparity).

Time disparity Such conflicts may be resolved using modified NPV and IRR using reinvestment
rate applicable to the firm.
Size disparity Such conflict may be resolved using incremental approach.

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Steps:
 Find out the differential cash flows between the two proposals
 Calculate the IRR of the incremental cash flows
 If the IRR > Cost of capital, the project with greater non-discounted net cash
flows should be selected.
Life disparity To resolve such conflict, compare the alternatives on the basis of their Equivalent
Annual Benefit (EAB) or Equivalent Annual Cost (EAC) and select the alternative
with the higher EAB or lower EAC.
EAB = NPV x Capital Recovery Factor OR NPV ÷ PVIFAk,n
EAC = PV of Cost ÷ PVIFAk.n

Risk and Uncertainty:

Uncertainty refers to the outcomes of a given event which are too unsure to be assigned probabilities,
while risk refers to a set of unique outcomes for a given event which can be assigned probabilities.
In investment decisions, cash outflows and cash inflows over the life of the project are estimated and on
the basis of such estimates, decisions are taken following some appraisal criteria (NPV, IRR, etc.).
Risk and uncertainties are involved in the estimation of such future cash flows as it is very difficult to
predict with certainty what exactly will happen in future.
Therefore, the risk is referred as the variability in actual returns in relation to the estimated return.

Standard Deviation and Coefficient of Variation:

Standard Deviation is considered as the best measures of dispersion or variability.
Higher value of standard deviation indicates higher variability and vice versa. Higher variability means
higher risk.
As future cash flows cannot be estimated with certainty, it involves risk. Therefore, risk in investment
analysis can be measured by using standard deviation.
Investment proposal with lower standard deviation will be preferred.

Standard deviation is an absolute measure of risk analysis and it can be used when projects under
consideration are having same cash outlay.

If the projects to be compared involve different outlays/different expected value, the coefficient of
variation is the correct choice, being a relative measure.

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Risk Adjusted Discount Rate (RADR) Method:

Risk adjusted discount rates method is used in investment and budgeting decisions to cover time value of
money and the risk. The use of risk adjusted discount rate is based on the concept that investors demands
higher returns from the risky projects.

High Risk Projects = Higher Discount Rate

Low Risk Projects = Lower Discount Rate
Risk Adjusted Discount Rate for Project is given by:
t
NPV =∑ { NCFt ÷ (1+K) }
RADR = Risk free rate + Risk premium

Certainty Equivalent Approach (CE Approach):

This is another method of dealing with risk in capital budgeting in order to reduce the forecasts of cash
flows to some conservative levels.
The certainty equivalent approach may be expressed as:
NPV =∑ { αt x NCFt ÷ (1+ Kf)t}
Where,
αt = the certainty equivalent coefficient (assumes value between 0 and 1 and varies inversely with risk)
Kf = risk- free rate of return

Certain cash flows = Estimated cash flows x certainty-equivalent coefficient (αt).

Capital budgeting Techniques under uncertainty:

Risk can be defined as the chance that the actual outcome will differ from the expected outcome.
Uncertainty relates to the situation where a range of differing outcome is possible, but it is not possible to
assign probabilities to this range of outcomes.
There are three different types of project risk to be considered:
1) Stand-alone risk: This is the risk of the project itself.
2) Corporate or within-firm risk: This is the total or overall risk of the firm when it is viewed as a
collection or portfolio of investment projects.
3) Market or systematic risk: Market risk is essentially the stock market‟s assessment of a firm‟s
risk, its beta, and this will affect its share price.

Statistical Techniques for Risk Analysis:

a) Probability Assignment
b) Expected Net Present Value
c) Standard Deviation
d) Coefficient of Variation
e) Probability Distribution Approach
f) Normal Probability Distribution

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Probability Assignment:
Probability may be defined as the likelihood of occurrence of an event.
If an event is certain to occur, the probability of its occurrence is 1 but if an event is certain not to occur,
the probability of its occurrence is 0. Thus, probability of all events to occur lies between 0 and 1.
Probability estimate which is based on a large number of observations is known as an objective
probability.
Such probability assignments that reflect the state of belief of a person rather than the objective evidence
of a large number of trials are called personal or subjective probabilities.

Expected Net Present Value:

Once the probability assignments have been made to the future cash flows, the next step is to find out the
expected net present value. It can be found out by multiplying the monetary values of the possible events
by their probabilities.
The following equation describes the expected net present value.
ENCFt = NCFt x Probability

t
ENPV = ENCFt ÷ (1+K)
Where-
ENPV is the expected net present value,
ENCFt expected net cash flows in period t and
k is the discount rate.

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CHAPTER-3

CAPITAL STRUCTURE AND LEVERAGE ANALYSIS

Capital structure means the break-up of the capital employed by a firm. The capital employed consists of
both the owners‟ capital (Equity) and the debt capital provided by the lenders.

An optimal capital structure is the best debt to equity ratio for a firm that maximises its value and
minimises the firm‟s cost of capital.

Type of Capital Structure:

Horizontal Capital In a Horizontal capital structure, the firm has zero debt components in the structure
Structure mix. Expansion of the firm takes place through equity or retained earning only.
Vertical Capital In a vertical capital structure, the base of the structure is formed by a small amount
Structure of equity share capital. The addition in the capital structure is almost entirely in the
form of debt.
Quantum of retained earnings is low and the dividend pay-out ratio is quite high.
Pyramid shaped A pyramid shaped capital structure has a large proportion consisting of equity
Capital structure capital and retained earnings.
Inverted Pyramid Such a capital structure has a small component of equity capital, reasonable level of
shaped Capital retained earnings but an ever increasing component of debt.
Structure

Capital structure vis-a-vis Financial structure:

Liabilities
Equity Share Capital
Reserves and Surplus (R.E)
Capital Structure
(Capital Employed) Preference Share Capital
Debentures
Long-term Borrowings
Financial structure

Current Liabilities:
Creditors
Bills Payable
Short term Borrowings
Outstanding Expenses

Capital structure = Financial structure - Current liabilities.

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CAPITAL STRUCTURE THEORIES:
Net Income According to this approach there is a relationship between capital structure and the
Approach value of the firm.
Ko = Kd x Wd + Ke x We
Assumptions:
a) Kd < Ke
b) Kd and Ke remains constant
c) No taxes.

Conclusion:
 Higher the Ko lower will be the value of the firm. Inverse relationship exists
between the value of the firm and overall cost of capital (Ko).
 Higher the debt portion in capital, higher will be the value of the firm.

Net Operating According to NOI Approach, the market value of the firm depends upon the EBIT and
Income Approach the overall cost of capital.
The capital structure is irrelevant and does not affect the value of the firm.
EBIT
Value of the firm =
Ko
Assumptions:
a) Ko and Kd of the firm is constant.
b) The use of more and more debt in the capital structure increases cost of equity
capital (Ke), and
c) No taxes.

Conclusion:
 Ke would go up or down with increasing or decreasing leverage (debt).
 It means that as we increase the level of debt in the company, the value of the firm
doesn‟t change.
Note: In practical situations, both these approaches seem to be unrealistic.

Traditional The traditional approach suggests that there exist an optimal debt to equity ratio where
Approach the Ko is the minimum and market value of the firm is the maximum.
As per this approach, debt should exist in the capital structure only up to a specific
point, beyond which, any increase in leverage would result in the reduction in value of
the firm.

Assumptions:
a) The rate of interest on debt remains constant for a certain period and thereafter
with an increase in leverage, it increases.
b) The Cost of equity remains constant or increase gradually. After that, the equity
shareholder starts perceiving a financial risk and then from the optimal point it
increases speedily.
c) The WACC (Ko) first decreases and then increases. The lowest point on the curve
is optimal capital structure.

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Modigliani - Miller Franco Modigliani and Merton Miller (MM) concluded that the value of a firm depends
Theory solely on its future earnings stream, and hence its value is unaffected by its debt/equity
mix.
Proposition – I:
Operating income (EBIT)
Total Value of the firm =
Appropriate discount rate
Proposition – II:
Ke = Ko + Premium.
Premium = Debt- Equity ratio x (Ko - Kd)
As the firm‟s use of debt increases its cost of equity also rises.
Proposition – III:
Investment and financing decisions are independent because the average cost of capital
(Ko) is not affected by the financing decision.

MEASURES OF OPERATING AND FINANCIAL LEVERAGE:

In the financial point of view, leverage refers the ability to use fixed cost funds to increase the return to its
shareholders i.e use of debt component in capital structure of the company.

Particulars Amount
Sales XXXX
Less: Variable cost (XXXX)
Contribution XXXX
Less: Fixed Operating cost (XXXX)
Operating Profit (EBIT) XXXX
Less: Interest (XXXX)
Profit before Tax (PBT) XXXX
Less: Tax (XXXX)
Profit after Tax (PAT) XXXX
Less: Preference Dividend (XXXX)
Profit available to Equity Shareholders XXXX
Less: Equity Dividend (XXXX)
Retained Earnings XXXX

Operating Expenses = Variable cost + Fixed Operating cost

Fixed Financing cost = Interest + Preference Dividend

Profit available to Equity Shareholders

EPS =
No. of Equity Shares

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TYPES OF LEVERAGE:
Operating leverage The leverage associated with investment activities is called as operating leverage. It is
caused due to fixed operating expenses in the company.
Contribution
Operating Leverage =
EBIT

Degree of Operating Leverage:

Percentage change in EBIT
DOL =
Percentage change in Sales
Financial leverage The leverage associated with financing activities is called financial leverage.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”.
EBIT ( Operating Profit)
Financial leverage =
PBT ( Profit Before Tax)

Degree of Financial Leverage:

Percentage change in PBT
DFL =
Percentage change in EBIT
Alternatively:
Percentage change in EPS
DFL =
Percentage change in EBIT
Financial leverage helps to examine the relationship between EBIT and EPS.
Combined leverage Combined leverage expresses the relationship between the revenue in the account of sales
and the taxable income.
Combined leverage = Operating Leverage x Financial leverage
Contribution
Combined Leverage =
PBT (Profit Before Tax)

Degree of Combined Leverage:

Percentage change in EPS
DCL =
Percentage change in Sales
Financial Break It is the level of EBIT at which EPS is zero.
Even Point EBIT = Interest + Tax + Preference Dividend

Note: Here, Earnings available to Equity shareholders is 0 i.e EPS will be 0.

Indifference Point It is the point at which different sets of debt ratios (percentage of debt to total capital
employed) gives the same EPS.
Indifference level is the level of EBIT beyond which the benefits of financial leverage
began to operate with respect to EPS.

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Working Capital Working capital leverage measures the sensitivity of return in investment of charges in the
leverage level of current assets.
Percentage change in ROI
WCL =
Percentage change in Working Capital
OR
Current Assets
WCL =
Total Assets + Change in Current Assets

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CHAPTER-4

SOURCES OF LONG TERM FINANCE AND COST OF CAPITAL

Liabilities
Equity Share Capital
Owner‟s Capital Reserves and Surplus (R.E)
Preference Share Capital Long term Funds
(Capital Employed)
Borrowed Capital Debentures
Long-term Borrowings

Current Liabilities:
Creditors
Bills Payable
Short term Borrowings
Outstanding Expenses

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture
etc. The capital required for these assets is called fixed capital. A part of the working capital is also of a
permanent nature. Funds required for this part of the working capital and for fixed capital is called long
term finance.

SOURCES OF LONG TERM FINANCE:

The two main sources of long term finance are as follows:

A. Ownership Capital
a) Equity share capital
b) Preference share capital
c) Retained earnings
B. Borrowed capital
a) Debentures
b) Term loans
c) Others

COST OF CAPITAL:

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of
generating funds in the marketplace.

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MEASUREMENT OF COST OF CAPITAL:
Cost of debt (Kd):
Cost of debt Cost of Debt refers to the cost of long term debentures/bond.
Kd after taxes = Kd (1 – tax rate)

Interest ( 1-t)
Kd =
Sale Proceeds / Issue Price
Cost of In case of debentures repayable after a certain period of time, cost of debt is calculated taking
Redeemable debt the average of sale value and redemption value.
I + (RV - SP) / n
Kd (before tax) =
(RV + SP ) / 2

Kd (after tax) = Kd (before tax) x ( 1- t )

Cost of Preference shares (Kp):

Cost of Irredeemable preference shares are those shares for which company has no obligation to pay
Irredeemable back the principal amount of the shares during its lifetime.
preference The only liability of the company is to pay the annual dividends.
shares Annual Preference Dividend
Kp =
Market price of the preference share

If the company issues new preference shares:

Annual Preference Dividend
Kp =
Net Sale Proceeds after floatation cost, if any

Cost of Redeemable preference shares are those shares which have a fixed maturity date at which they
Redeemable would be redeemed.
preference PD + (RV - SP) / n
shares Kp =
(RV + SP ) / 2
Note: SP = Sale Proceeds or Issue Price
RV = Redemption Value or Repayable amount

Cost of Equity capital:

There is no coupon rate in case of equity shares. Further, there is no commitment to pay equity dividends and it is
the sole discretion of the Board of directors to pay or not to pay dividends and what rate.
CAPM model This is a popular approach to estimate the cost of equity.
Ke = Rf + (Rm - Rf ) ß
Note: Rf = Risk-free rate
Rm = Equity market required return
ß = Systematic Risk Coefficient.

Bond Yield Plus Cost of equity = Yield on long-term bonds + Risk Premium.
Risk Premium
Approach

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Dividend D1
Growth Model P0 =
(r - g)
Approach
D1
r (ke) = + g%
P0
Note: D1 = Dividend at the end of the year
g = Constant growth rate

Earnings-Price E1
Ratio approach ke =
P0

E1 = (Current EPS) x (1 + growth rate of EPS)

Cost of Retained The cost of retained earnings is often taken as equal to the cost of equity.
Earnings Therefore we can say, ke = kr.

Weighted Average Cost of Capital:

The weighted average cost of capital (WACC), as the name implies, is the weighted average of the costs
of different components of the capital structure of a firm. WACC is calculated after assigning different
weights to the components according to the proportion of that component in the capital structure.
WACC = Kd x Wd + Kp x Wp + Ke x We

The weights to be used for calculation of WACC can either be based on the book value or the market
value of the funds raised from different sources.

Marginal Cost of Capital (MCC):

MCC is the cost of additional capital introduced in the capital structure.

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CHAPTER-6

DIVIDEND POLICY

Dividend policy determines what portion of earnings will be paid out to stock holders as dividend and
what portion will be retained in the business to finance long-term growth.

TYPES OF DIVIDEND POLICIES:

Regular dividend In this type of dividend policy the investors get dividend at usual rate. Here, the
policy investors are usually persons who want to get regular incomes.
Stable dividend It is of three types:
policy a) Constant dividend per share: In this case, fixed amount of dividend is paid
every year.
b) Constant payout ratio: In this case, a fixed percentage of earning is paid as
dividend every year.
c) Stable rupee dividend + extra dividend: Under this type, fixed amount of
dividend + extra dividend in the year when the company earns high profit in the
form of bonus is paid.
Irregular dividend Here the company does not pay regular dividend to the shareholders.
No dividend Here the company does not pay any dividend to the shareholders.
The company may use this type of dividend policy due to requirement of funds for the
growth of the company or for the working capital requirement.

TYPES OF DIVIDEND/FORMS OF DIVIDEND:

Cash Dividend Stock Dividend Bond Dividend Property

Dividend

Dividend is paid in the It is paid in the form of the Bond dividend is also A property
form of cash to the company stock. Stock known as script dividend can
shareholders dividend may be bonus dividend. Here the either include
shares of a
issue which is issued only company promises to
subsidiary
to the existing pay the shareholder company or
shareholders. at a future specific physical assets.
date with the help of The dividend is
issue of bond or recorded at the
notes. market value of
the asset provided.

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THEORIES OF DIVIDEND:
Dividend decision consists of two important concepts which are based on the relationship between
dividend decision and value of the firm.

Theories of
Dividend

Relevance
Irrelevance
of
of dividend
Dividend

Walter‟s Gordon‟s M.M.

Model Model Approach

Relevance of Dividend:
If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case a change in
the dividend payout ratio will be followed by a change in the market value of the firm.
Optimum payout ratio is the ratio which gives highest market value per share.
Walter’s Model Walter used the following formula to find out price per share:
D Rxr
P= +
K K2
Where:
P = Current Market price
D = Dividend per share
R = Retention per share
r = return on investment of the company
ke = Market capitalization rate/ Discounting rate/ Cost of Equity

If r > ke, the firm should retain the entire earnings, whereas it should distribute the
earnings to the shareholders in case the r < ke.
Conclusion:
a) Growth Firms (r > ke):- Optimum payout ratio is 0%.
b) Normal Firms (r = ke):- All the payout ratios are optimum.
c) Declining Firm (r < ke):- Optimum payout ratio is 100%.

Gordon’s Model Gordon used the following formula to find out price per share:
E (1-b)
P=
k-g
Where,
P = Current Market price of a share
E = Earnings per share
b = Retention ratio or percentage of earnings retained or (1 – Payout ratio)
g = br (growth rate)

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r = rate of return on investment of an all equity firm.
Conclusion:
a) Growth Firms (r > ke):- Optimum payout ratio is 0%.
b) Normal Firms (r = ke):- All the payout ratios are optimum.
c) Declining Firm (r < ke):- Optimum payout ratio is 100%.

Gordon‟s Model‟s conclusions about dividend policy are similar to that of Walter. This
similarity is due to the similarities of assumptions of both the models.
Irrelevance of Dividend:
If the dividend policy doesn‟t affect the value of a firm, it is considered as irrelevant.
M.M. According to the theory the value of a firm depends solely on its earnings power resulting
Approach from the investment policy and not influenced by the manner in which its earnings are
split between dividends and retained earnings.
Investors are indifferent to dividends and capital gains and so dividends have no effect on
the wealth of shareholders.
D1 + P1
P0 =
1+K
Where:
P0 = Current market price per share
K = Capitalisation rate (assumed constant throughout)
D1 = Dividend per share at the end of year-1.
P1 = Expected market price per share at the end of year-1.

Total fund requirement for investment proposal is “I”

Dividend to be paid at the end of year-1 = D1 x n
Retained earnings available for investment proposal = E – (nD1)
External fund is to be raised by issue of “m” number of equity shares at the price of P1.
So we can write the following equation:
mP1 = I – [E – nD1]

P1(m + n) - I + E
Value of the firm =
1+K

Marginal Analysis and Residual Theory of Dividend:

The residual theory of dividend assumes that if the firm has retained earnings left over after financing all
acceptable investment opportunities, these earnings would then be distributed to shareholders as cash
dividends. If no funds are left, no dividend will be paid. In such a case, the dividend policy that results is
a strictly a financing decision. As a result the payment of cash dividend is a passive residual.

Thus, if the available investment opportunities are plenty, the percentage of dividend payout will be 0. On
the other hand, if the firm is unable to find profitable investment opportunities, the dividend payout ratio
is likely to be 1.

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CHAPTER-7

WORKING CAPITAL MANAGEMENT

The capital which is required to finance current assets is called working capital. It is the capital of a
business which is used to carry out day-to-day business operations of a firm.

Working Capital = Current assets – Current Liabilities

OPTIMUM WORKING CAPITAL:

A firm should neither have too high an amount of working capital nor should the same be too low. It is
the job of the finance manager to estimate the requirements of working capital carefully and determine the
optimum level of investment in working capital.

If a company‟s current assets do not exceed its current liabilities, then it may run into trouble with
creditors that want their money quickly. Current ratio and acid test ratio has traditionally been considered
as the best indicator of the working capital situation.

Current Ratio Current Assets It is a simple measure that estimates

Current Liabilities whether the business can pay short term
debts. Ideal ratio is 2:1.
Quick Ratio (acid Quick Assets It measures the ability to meet current
test ratio) Current Liabilities debt immediately. Ideal ratio is 1:1.

TYPES OF WORKING CAPITAL:

Initial working The capital, which is required at the time of the commencement of business, is called
capital initial working capital.
Regular working This type of working capital remains invested in the enterprise for the successful
capital operation. It supplies the funds necessary to meet the current working expenses i.e. for
purchasing raw material and supplies, payment of wages, salaries and other sundry
expenses.
Fluctuating working This capital is needed to meet the seasonal requirements of the business. It is used to
capital raise the volume of production by improvement or extension of machinery.
Reserve margin It represents the amount utilized at the time of contingencies.
working capital
Permanent and To carry on a business, a certain minimum level of working capital is necessary on a
Temporary Working continuous and uninterrupted basis which is known as permanent or fixed working
Capital capital.
Any amount over and above the permanent level of working capital is temporary,
fluctuating or variable working capital.
Long Term working The long-term working capital represents the amount of funds needed to keep a company
capital running in order to satisfy demand at lowest point.
Short term working Short-term capital varies directly with the level of activity achieved by a company. The
capital Volume of Operation decides the quantum of Short-term working capital.

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Gross Working Gross working capital refers to the firm's investment in current assets.
Capital
Net Working Capital Net working capital refers to the difference between current asset and Current liabilities.

DETERMINANTS OF WORKING CAPITAL:

Working capital management is concerned with:-

a) Maintaining adequate working capital (management of the level of individual current assets and
the current liabilities) and
b) Financing of the working capital.

Finance Manager needs to plan and compute the working capital requirement for its business. And once
the requirement has been computed, he needs to ensure that it is financed properly. This whole exercise is
nothing but Working Capital Management.

Approaches of working capital investment:

Based on the organisational policy and risk-return trade off, working capital investment decisions are
categorised into three approaches i.e-
Aggressive Conservative Moderate
Here investment in working In this approach of organisation use This approach is in between the
capital is kept at minimal to invest high capital in current above two approaches. Under this
investment in current assets assets. Organisations use to keep approach a balance between the
which means the entity does hold inventory level higher, follows risk and return is maintained to
lower level of inventory, follow liberal credit policies, and cash gain more by using the funds in
strict credit policy, keeps less balance as high as to meet any very efficient manner.
cash balance etc. current liabilities immediately.

Current assets and Fixed assets financing:

Working capital financing or current assets financing is done by raising short-term loans or cash credits
limits but fixed assets financing is done by raising long-term loans or equity.

OPERATING OR WORKING CAPITAL CYCLE:

The operating cycle is the length of time between the company‟s outlay on raw materials, wages and other
expenditures and the inflow of cash from the sale of the goods. Management has to remain cautious that
the operating cycle should not become too long.

Operating Cycle = Cash Raw material Work-in-progress Finished goods Receivables

(Debtors) Cash
In the form of an equation, the operating cycle process can be expressed as follows:

Operating Cycle = R + W + F + D – C

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The various components of operating cycle can be calculated as shown below:
Name of Working Capital Component Formula
Raw materials
Period of raw material stock Average Stock of Raw material
Consumption of raw material per day

Average level of Creditors

Less: Period of credit granted by Supplier
Purchase of raw material per day
Period of Production Average Stock of work in progress
Average cost of production per day
Period of turnover of finished goods stock Average Stock of finished goods
Average cost of goods sold per day
Period of credit taken by customers Average receivable
Average value of credit sales per day
Total operating cycle period Sum of Sl. Nos. 1, 2, 3, 4

WORKING CAPITAL REQUIREMENT ASSESSMENT:

The formula which is used for assessing the working capital requirement is given below:
Current Assets: Amount
Value of Raw Material Stock XXXX
Value of Work in Progress XXXX
Value of Finished Goods Stock XXXX
Value of Trade Receivables XXXX
Value of Cash Required XXXX
Total (A) XXXX
Current Liabilities:
Value of Trade Payable XXXX
Value of Bank Overdraft XXXX
Value of Outstanding expenses XXXX
Total (B) XXXX
Working Capital (A – B) XXXX

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INVENTORY MANAGEMENT:

Inventory Management is the second important segment of working capital management Inventory is the
second step in the operating cycle wherein cash in converted into various items of the inventory.
Inventory has the following major components:
a) Raw Material
b) Work in Process
c) Finished Goods.

Strategy for Inventory Management:

A successful strategy for inventory management has at its core the objective of holding the optimum level
of inventory at the lowest cost.

The cost of holding inventory has the following three elements:

Carrying Cost Ordering Cost Stock-out Cost
This is the cost of keeping or It is the cost associated with It is the cost associated with
maintaining the inventory in a placing each individual order for procuring an inventory item,
usable condition. This includes supply of raw materials, stores, which has gone out of stock and
the storage costs. packing materials etc. is needed for immediate supply.
If inventory level rises, its If these items are procured in This cost includes the reduction
carrying cost also rises. small lots, then the ordering cost of profit and costs accruing due
per unit of inventory would be to disruption in the operating
more and vice versa. cycle.

Managing the Inventory Level:

1) Economic Order Quantity (EOQ) Model:
EOQ is the lot size at which the total of ordering cost and carrying cost will be lowest or least.
EOQ can be calculated by using the following formula-

This model determines the order size that will minimize the total inventory cost.
Assumptions underlying EOQ:
a) Ordering cost per order and carrying cost per unit per annum are known and are fixed.
b) Expected usage or requirement of material in units is known.
c) Cost per unit of material (Purchase Price) is constant and is known as well.
d) Lead time is 0.
Total Ordering Cost = [Annual demand / Lot size] x Ordering cost per order

Total Carrying Cost = ½ x Lot size x Carrying cost per unit per annum

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Note: At EOQ level, Total ordering cost = Total carrying cost.

Re-order Level = Normal Lead Time x Normal Usage

2) ABC Analysis:
It is a system of inventory control under which inventories are classified into 3 categories i.e
A,B and C on the basis of investment involved.
Category Quantity Investment Value Price Control
A 10% 70% Expensive Precise control
B 20% 20% Average Moderate control
C 70% 10% Cheap Least control

CASH MANAGEMENT:

By cash management, we mean the management of cash in currency form, bank balances and readily
marketable securities. Cash is the most important component of working capital of a firm. It is also the
terminal conversion point for other constituents.

The various forms of cash holding:

Cash is considered to be the most liquid of current assets. It is held either as cash balances with the firms
or in bank accounts.

There are two ways of holding bank balances – first as current accounts through which the day to day
transactions of the firm are carried out and secondly as fixed deposits in which balances are held for a
specified fixed period. Current account balances are most liquid.

Motives for holding cash:

Transactional Motive This is the most essential motive for holding cash because cash is the medium through
which all the transactions of the firm are carried out.
Speculative Motive If cash is kept idle, it becomes a liability rather than an asset. Efficient firms seek to
deploy surplus cash in short term investments to get better returns. Since the
deployment of cash needs to be done skillfully, not all the firms hold cash for
speculative motive.
Contingency Motive This motive of holding cash is to meet uncertainty associated with the business.

William J. Baumal Model for Optimal Cash Balance Management:

Cash management model of William J. Baumal assumes that the concerned company keeps all its cash on
interest yielding deposits from which it withdraws as and when required. It also assumes that cash usage
is linear over time. The model is almost same as economic stock order quantity model.

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Where,
T= Projected cash requirement
b = Conversion cost per lot
I= Interest earned on marketable securities per annum (in rate).

At this level, Total of Cost of withdrawal and Interest foregone will be minimum AND
Cost of Conversion (withdrawal) = Interest foregone by holding cash

RECEIVABLES MANAGEMENT:

Receivables are generally referred to by the name of “Sundry Debtors” in the books of account i.e. those
persons which owe payment to the firm for goods supplied or services rendered on credit. So long as the
sundry debtors persist, the firm is strained of cash. So, logically the firm seeks to minimize the level of
sundry debtors.

The period of credit allowed to debtors depends upon position of the firm in the industry and the industry
practice.

How do firms ensure realisations?

Timely realisation of receivables is an important element of working capital management. Practices in

this respect vary from firm to firm. Most of the firms dissuade credit sales to first time customers and
gradually allow credit after development of relationship. While giving credit, some firms obtain postdated
cheques from their clients. In other cases, firms have special staff earmarked for recovery efforts.

The firm may follow a lenient or a stringent credit policy. The firm which follows a lenient credit policy
sells on credit to customers on very liberal terms and standards.

On the contrary a firm following a stringent credit policy sells on credit on a highly selective basis only to
those customers who have proper credit worthiness and who are financially sound.

Factoring services:

Factoring is a financial service in which the business entity sells its Trade receivables/debtors to a third
party at a discount in order to raise funds. The Bank/Financial institution purchasing the receivable is
known as factor.

Factoring may be with or without recourse. „With recourse‟ means bad debts loss if any will be suffered
by „supplier‟. Non-recourse factoring or without recourse means bad debts loss will be suffered by factor
itself.

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CHAPTER-8

SECURITY ANALYSIS

Investment means to forego present consumption for the increased consumption resource available in the
future.

An investor can buy a share of a company in anticipation of getting good returns in future.

Financial assets are different from real assets. While financial assets are the paper claim representing an
indirect claim to real assets in form of debt or equity commitments and real assets are land and building,
machines, etc., which are used to produce goods and services.

Financial assets are Liquid and marketable.

Any investment decision will be influenced by three objectives – Security, Liquidity and Yield.
A best investment decision will be the one, which has the best possible compromise between these three
objectives.

WHAT ARE SECURITIES?

Securities may be defined as instruments issued by seekers of funds in the investment market to the
providers of funds in lieu of funds.

These instruments prima facie provide evidence of ownership to the holder of the instrument. The owner
is entitled to receive all the benefits due on the instrument and to retrieve his investment at the time of
redemption. Securities can broadly be divided into two categories – Debt Securities and Equity Securities.

SECURITY ANALYSIS:

Security Analysis is primarily concerned with the analysis of a security with a view to determine the
value of the security, so that appropriate decisions may be made based on such valuation as compared
with the value placed on the security in the market.

Two basic approaches of security analysis are fundamental analysis and technical analysis.

FUNDAMENTAL ANALYSIS:

Fundamental analysis is a three level systematic process that analyse the overall external and internal
environment of the company before placing a value on its shares:
a) Analysis of the economy (economic analysis)
b) Industry Level Analysis
c) Company Analysis

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Analysis of the economy:

If the country has an improving GDP growth rate, On the other hand, if the GDP growth rate slackens,
controlled inflation and increasing investment activity inflation is out of control and investment activity is
then chances are that the valuation of securities shall stagnant or declining.
be liberal.
As the economy is growing, the analyst expects almost Investor or the analyst will expect the performance of
every industry to do well. industries to slow down.
The capital market is said to be in a bullish phase with The capital market enters a bearish phase and share
share values shooting up. values decline.

Industry Level Analysis:

Industry is a combination or group of units whose end products and services are similar. Having a
common market, the participants in the industry group face similar problems and opportunities.

The industry life cycle or the industry growth cycle can be divided into three major stages- Pioneering
stage, Expansion stage and Stagnation stage.

Pioneering stage The pioneering stage is related to sunrise status of the industry.
 Technological development takes places.
 Products are newly introduced into the market.
 Industry makes extraordinary profits and attracts competition.
 As competition increases profitability in the industry comes under strain and less
efficient firms are forced out of the market.
At the end of the pioneering stage, selected leading companies remain in the industry.
Expansion stage In this stage, demand for the products increases but at a lower rate.
 Less volatility in prices and production.
 Capital is easily available in plenty for these units.
Stagnation stage At this stage, the growth rate initially slows down, then stagnates and ultimately turns
negative.
 No product innovation.
 External capital is hard to come by.
This stage of the industry is most valuable during times of slowdown in national economy.

Company Analysis:

The analyst looks at the company specific information. Company information is generated internally and
externally. The principle source of internal information about a company is its financial statements. There
are traditional and modern techniques of company analysis.

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TECHNICAL ANALYSIS:

An alternative approach to predict share price behavior is Technical Analysis. It is used in conjunction
with fundamental analysis and not as its substitute.

Technical analysis is an analysis for forecasting the direction of prices through the study of past market
data, primarily price and volume. This Technique assumes market prices of securities are determined by
the demand- supply equilibrium.

RISK AND ITS TYPES:

Risk in security analysis is generally associated with the possibility that the realized returns will be less
than the expected returns.

Types of risk

Systematic risk Unsystematic risk

Influence of External Influence of Internal factors
factors
Controllable by an
Uncontrollable by an organsiation
organsiation
Micro in nature
Macro in nature

Systematic risk

Interest Rate Risk Market Risk Purchasing

Power/Inflationary Risk

Now let’s discuss each risk classified under this group-

1. Interest rate risk:
Interest-rate risk is the variation in the single period rates of return caused by the fluctuations in
the market interest rate. It particularly affects debt securities as they carry the fixed rate of interest.
2. Market risk:
Market risk arises due to rise or fall in the trading price of listed shares or securities in the stock
market.
3. Purchasing power or inflationary risk:
Purchasing power risk is also known as inflation risk as it reduces the purchasing power of money.

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Unsystematic risk

Business Risk/ Liquidity Risk Financial Risk/ Credit Risk

Now let’s discuss each risk classified under this group-

1. Business or Liquidity risk:
It originates from the sale and purchase of securities affected by business cycles, technological
changes, etc.
2. Financial or Credit risk:
It arises due to change in the capital structure of the organization.

RETURN OF THE SECURITY:

Return is the primary motivating force that drives investment. It represents the reward for undertaking
investment. Taxes, inflation, commissions, and the timing of cash flows all play major roles in “correct”
calculation of returns.

The return of an investment consists of two components:

Current Return: It is the periodic cash flow (income), such as dividend or interest, generated by the
investment.

Capital Return: It is reflected in the price change– it is simply the price appreciation (or depreciation)
divided by the beginning price of the asset.

Total return = Current return + Capital return

Current return can be zero or positive, whereas the capital return can be negative, zero or positive.

MEASURING RETURN:

Holding period return is the total return received from holding an asset or portfolio of assets over a period
of time, generally expressed as a percentage.

Holding Period Return = [Income + (End of Period Value – Initial Value)] / Initial Value

Annualized HPR = {[(Income + (End of Period Value – Initial Value) / Initial Value] + 1}1/n – 1,
Where, n = number of years.

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APPROACHES TO VALUATION OF SECURITY:

Security analysis begins with assessing the intrinsic value of security. There are three main schools of
thought on the matter of security price evaluation.

1) The Fundamental Approach:

The Fundamental approach suggests that every stock has an intrinsic value.
Equity valuation where the expected holding period is 1 year-
D1 + P1
P0 =
1+r

Intrinsic value(P0) > Market value(MPS) = Buy a Security

Intrinsic value(P0) < Market value(MPS) = Sell a Security

Where dividends will grow at the constant rate for indefinite period -
D1
P0 =
(r - g)

2) Technical Approach:
The technical analyst endeavours to predict future price levels of stocks by examining one or many
series of past data from the market itself. The basic assumption of this approach is that history tends
to repeat itself and the price of a stock depends on supply and demand in the market and has little
relationship with its intrinsic value.

3) Efficient Capital Market Theory:

The theory is popularly known as “Efficient Capital Market Hypothesis: (ECMH). The advocates of
this theory contend that securities markets are perfect, or at least not too imperfect. The theory states
that it is impossible to beat the market. Efficient market theorists contend that a share or stock is
generally worth whatever it is selling for.

Face value/ Nominal value: Face value of the security is the denominating value. It is the amount of
share capital divided by number of shares. It is the value at which Share capital will be appearing in the
balance sheet.

Book value: The book value may be much more than the face value. It is the price at which shares are
issued including premium i.e issue price.

Market value: Market value is the price at which shares are traded in the market.

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CHAPTER-9

PORTFOLIO MANAGEMENT

A portfolio refers to a collection of investments such as stocks, shares, mutual funds, bonds, cash and so
on. Portfolio Management refers to the selection of securities and their continuous shifting in the Portfolio
for optimizing the return for a given level of risk and maximizing the wealth of an investor.

The Investment process consists of two tasks-

 The first is security analysis which focuses on assessing the risk and return characteristics of the
available investment alternatives.
 The second task is portfolio selection which involves choosing the best possible portfolio from
the set of feasible portfolios.

Harry Markowitz was the first person to show quantitatively why and how diversification reduces risk.

PORTFOLIO ANALYSIS:

Portfolio Analysis is primarily the study of certain portfolio regarding its performance, ROI and
associated risks. Portfolio analysis is conducted with two objective viz. minimizing the risk and
maximizing the returns. Portfolio, or combination of securities, helps in spreading this risk over many
securities.

Portfolio management thus refers to efficiently management of the investment in the securities by
diversifying the investments across industry lines or market types.

EXPECTED RETURN ON A PORTFOLIO:

A. Based on Past Returns of Stock:

The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the
stocks which comprise the Portfolio.
Expected Return of Portfolio = WA×RA+WB×RB+.....+Wn×Rn

B. Based on Probability of Expected Returns of the Portfolio:

Expected Return is the Mean Return computed on the basis of the probability of returns expected from the
each security in the portfolio.

Expected Return of a Security = p1x1 + p2x2 + p3x3

Where,
p = Probability of each return from the security
x = Expected return from the security

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The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the
stocks which comprise the Portfolio i.e the formula given in Point A will be used.

RISK IN INVESTMENT SITUATION:

Risk means that the return on investment would be less than the expected rate. The risk involved in
individual securities can be measured by standard deviation or variance.

Components of Risk:

Total Risk (ϭ) = Systematic Risk + Unsystematic Risk

a) Systematic Risk: It is attributable to factors that affect the market as a whole. Beta(β) is a
measure of Systematic Risk.
b) Unsystematic Risk: It is the residual risk or balancing figure, i.e. Total Risk less Systematic Risk.

Measure of Risk:

The Total risk is measured by standard deviation. The Standard Deviation is a measure of how each
possible outcome deviates from the Expected Value. The higher the value of Standard Deviation, the
higher is the risk associated with the Portfolio and vice-versa. Standard Deviation is the average or mean
of deviations. It measures the risk in absolute terms.

It is denoted by Sigma(ϭ),

Where, N is the population size and µ is the population mean.

When Probability is given-

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Co-Variance as a Measure of Risk:

Covariance is an absolute measure of co-movement between two variables, i.e. the extent to which they
are generally above their means or below their means at the same time.

COVxy = 1/n [(x1 -E(X)) (y1 – E(Y))] + [(x2 -E(X)) (y2 – E(Y))]

Where the probabilities are equal and

COVxy = Covariance between x and y
x = return on security x
y = return on security y
E(X) = expected return on security x
E(Y) = expected return on security y
n = number of observations

Where the probabilities are given-

COVxy = P1[(x1 -E(X)) (y1 – E(Y))] + P2 [(x2 -E(X)) (y2 – E(Y))]

Coefficient of Correlation:
The coefficient of correlation is a measure designed to indicate the similarity or dissimilarity in the
behavior of two variables.
COV xy
Cor (xy) = rxy =
S.Dx X S.Dy

Where,
rxy = coefficient of correlation between x and y
COV xy = covariance between x and y
S.Dx = standard deviation of x
S.Dy = standard deviation of y

If
rxy = -1.0, perfect negative correlation exists between two securities
rxy = +1.0, perfect positive correlation exists between two securities
rxy = 0, two securities are independent of one another

Thus, correlation between two securities depends upon the covariance between the two securities, and the
standard deviation of each security and it lies between +1 and -1.

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Calculation of Portfolio Risk:

In considering a two-security portfolio, portfolio risk can be defined more formally now as:

Where:
ϭp = Portfolio standard deviation
wx = Percentage weightage of total portfolio value in stock X
wy = Percentage weightage of total portfolio value in stock Y
ϭx = Standard deviation of stock X
ϭy = Standard deviation of stock Y
rxy = Correlation coefficient between X and Y
COV xy = covariance between x and y

Simple Markowitz Portfolio Optimization:

It is possible to develop a fairly simple decision rule for selecting an optimal portfolio for an investor that
can take both risk and return into account. This is called a risk-adjusted return.
Risk-adjusted return/Utility = Expected Return - Risk Penalty
Risk penalty = Risk squared ÷ Risk tolerance
The optimal (best) portfolio for an investor would be the one from the opportunity set (efficient frontier)
that maximizes utility.

Security Market Line:

For well-diversified portfolios, nonsystematic risk tends to be zero, and the only relevant risk is
systematic risk measured by beta.
The equation of a straight line is-
Ri = RF + βi (RM – RF)

Recall that the risk of any stock could be divided into systematic and unsystematic risk. Beta is an index
of systematic risk. This equation suggests that systematic risk is the only important ingredient in
determining expected returns. Unsystematic risk is of no consequence. It is not total variance of returns
that affects returns, only that part of the variance in returns that cannot be eliminated by diversification.

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CALCULATION OF BETA:

Beta measures systematic risk i.e. that which affects the market as a whole, an investor who invests his
money in a portfolio of securities; Beta is the proper measure of risk. Beta of a security measures the
sensitivity of the security with reference to a broad based market index like BSE Sensex, NIFTY.
S.DS x r(RS,RM)
Beta of Security(βs) =
S.DM

S.DS = Standard Deviation on Security „S‟

S.DM = Standard Deviation of Market
r(RS,RM) = Extent of Correlation between Security S and Market Return

Beta of a portfolio:
Portfolio beta refers to the weighted-average beta coefficient of the individual investments in a portfolio.
Beta of Portfolio (βp) = Wxβx + Wyβy + Wzβz
Where,
X, Y & Z is the securities in the portfolio.
Wx, Wy & Wz are the Weights of securities in the portfolio.

It can also be calculated by using the above formula by replacing P in place of S-

S.DP x r(RP,RM)
Beta of Portfolio(βp) =
S.DM

Capital Market Line (CML):

The Capital Market Line (CML) provides the best risk and return tradeoff for an investor. CML enables
an investor to estimate the Expected Return from a Portfolio.

Market Price of Risk-

Market Price of Risk of Portfolio X (γ) = (RM - RF ) ÷ S.DM
Where,
RM = Market Return
RF = Risk Free Rate of Return
S.DM = Standard Deviation of the Market Portfolio.

Expected Return on Portfolio E(RP) = RF + S.DP * γ

Where,
E(RP) = Expected Return on Portfolio
RF = Risk Free Rate of Interest/ Return
γ = Market Price of Risk, i.e. Risk Premium per Unit of Market Risk
S.DP = Risk of the Portfolio (Standard Deviation)

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 Financial Management Revision Notes
SIMPLE SHARPE PORTFOLIO OPTIMIZATION:

The Sharpe ratio is quite simple, which lends to its popularity. It's broken down into just three
components: asset return, risk-free return and standard deviation of return.

(RX – RF)
S(X) =
S.DX
The idea of the ratio is to see how much additional return you are receiving for the additional volatility of
holding the risky asset over a risk-free asset - the higher the better.

(Ri – RF)
βi
Where:
Ri = expected return on stock i
RF = return on a riskless asset
βi = expected change in the rate of return on stock i associated with a 1% change in the market return

The first ratio to measure risk-adjusted return was the Sharpe Ratio introduced by William F. Sharpe in
1966.

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